Challenges Ahead For The UK Economy

12 July 2017

Challenges Ahead for the UK Economy

To say that the UK faces an enormous challenge ahead is something of an understatement. This general election result has ushered in a minority Conservative Government which offers the party (with support from The Democratic Unionist Party in Northern Ireland) only a very tenuous grip on power. It is from this precarious position that the Government must negotiate arguably the most important (and potentially most contentious) trade negotiation in its history.

Sterling Down But Not Out

The implications of this election result for sterling can be characterised as something of a Curate’s Egg. For a currency so dependent on foreign investor support, there is no doubt that this election result is negative for the pound. But there are some factors which should limit the downside for the currency. In terms of sterling negatives, investors will not like the renewed uncertainty this election has injected into the Brexit negotiating process. They will also be concerned that the compromise and introspection implicit in a minority Government will undermine the strength of the UK’s negotiating position. In addition, investors will also have (longer term) concerns about the big shift in sentiment of the UK voting public towards a left-wing (less market friendly) policy agenda (with less attention on reducing taxation, debt and deficit levels). That said there are some positive implications for sterling that offer a degree of downside protection. The pound is not at risk of collapsing. For one thing, this election result may in some ways increase the preparedness of the Government to compromise on EU strictures in relation to the free movement of people – one of the foundation pillars of the single market. It is possible that a negotiated compromise can be worked out which leaves the UK better placed with respect to retaining some degree of access to the Customs Union. This, in isolation, could be a huge positive for sterling. But also, the retreat in support for the Scottish Nationalist Party is significant and very much lowers the probability of another referendum on Scottish independence. Again, in isolation, this is another positive for sterling.

Equity Strategy

The weaker sterling outlook is positive for the big exporters. It’s also positive for the large-cap global companies that dominate the FTSE 100. These big international companies should be more resilient to UK economic weakness and should also benefit as the weaker exchange rate lifts the sterling value of foreign currency earnings for these companies. This represents something of an echo of last summer’s post-referendum experience in which the sudden drop in sterling resulted in a significant outperformance of the global FTSE 100 index versus the smaller-cap, more domestically-focused FTSE 250 index. One consequence of the additional uncertainties of Brexit negotiations is that the economy will likely be weaker and interest rates likely to remain lower for longer. We think the Bank of England will continue to regard the rise in inflation induced by the fall in the pound as a short-term phenomenon. This means that defensive (i.e. less cyclical) sectors of the equity market, such as consumer staples, utilities and telecoms, should be better supported. Financials, however, are likely to find the going a little tougher.

Don Smith

Chief Investment Officer

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